Estimating the cost of capital

The weighted average cost of capital, WACC is the opportunity cost of choosing to invest in the assets generating the free cash flow (FCF) of that business as opposed to another business of similar risk.

For consistency, the estimate of the WACC should have the following properties:

1. it includes the opportunity cost of all investors,
2. it uses the appropriate market-based weights,
3. it includes related costs/benefits such as the interest tax shield,
4. it is computed after corporate taxes, 
5. it is based on the same expectations of inflation as used in the FCF forecasts, and 
6. the duration of the securities used in estimating the WACC equals the duration of the FCFs.

Given:
D/V = target weight in debt
E/V = target weight in equity
kd = required return of debt as source of capital
ke = required return of equity as source of capital
Tm = marginal tax rate

WACC = D/V * kd (1 - Tm) + E/V * ke



Cost of equity

The capital asset pricing model (CAPM) is a popular way to estimate the cost of equity.

It includes an estimate of

• the risk free rate, 
• beta, and 
• the market risk premium.

Estimated equity risk premium
= risk free rate + Beta x (market risk premium)
= risk free rate + Beta x (market risk - risk free rate)


Note:  there are alternatives to the CAPM such as the Fama-French three factor model and the arbitrage pricing theory.


Cost of debt

The after tax cost of debt requires

• an estimate of the required return on debt capital and 
• an estimate of the tax rate.

Other estimates include the weights in the target capital structure and, when relevant, the effects of debt equivalent and the effects of a complex capital structure

Equity Risk Premium: Stock bubble? No way, says Alan Greenspan

Stock bubble? No way, says Alan Greenspan

Former Federal Reserve chairman Alan Greenspan says the stock market has room to rise from record levels.

“In a sense, we are actually at relatively low stock prices,” Mr Greenspan, who guided the central bank for more than 18 years, told Bloomberg Television overnight. “So-called equity premiums are still at a very high level, and that means that the momentum of the market is still ultimately up.”

The Standard & Poor’s 500 Index advanced 23 per cent this year through yesterday, pulling within a percentage point of its 23.5 per cent surge in 2009, amid speculation the Fed will delay cuts to its monthly bond purchases until the labour market improves.

Mr Greenspan said the stock market was “just barely above 2007” and the average annual increase in stock prices “throughout the postwar period” was 7 per cent, which leaves room for a rise.

“Price-earnings ratios are not hugely up,” he said. The market has “gone up a huge amount, but it’s not bubbly,” according to Mr Greenspan.

Mr Greenspan, 87, served at the Fed during an era dubbed the “Great Moderation” for its economic stability. In a December 1996 speech, after seven straight quarters of gains in the S&P 500, Mr Greenspan posed a question about how the Fed can know “when irrational exuberance has unduly escalated asset values.”

In the final years of Greenspan’s term, which lasted from 1987 to 2006, a massive housing bubble developed as home prices more than doubled between 2000 and 2006, according to the S&P/Case-Shiller home price index.
Mr Greenspan said today’s housing market doesn’t show the same conditions as it exhibited leading up to the housing crash, and is lending stability to the US economy.

“The level of construction has come up quite substantially, but it’s still only a third of where we were at the previous top,” Mr Greenspan said. “While housing has been a major contributor to what stability we have in the economy, it has not moved considerably.”

Purchases of new US homes rose in August, capping the weakest two months this year, showing the fallout from mortgage rates at a two-year high is cooling the real-estate rebound. Sales increased 7.9 per cent to a 421,000 annualised pace following a 390,000 rate in the prior month that was less than previously estimated, Commerce Department data showed September 25.


Mr Greenspan also praised Fed vice-chairman Janet Yellen, whom President Barack Obama has nominated as the next head of the central bank, both in the Bloomberg interview and in an earlier interview on CNBC.

“She’s a very bright lady,” Mr Greenspan said of Ms Yellen on CNBC. “I think she will surprise everybody, I mean in a positive way.”

Bloomberg


Read more: http://www.smh.com.au/business/markets/stock-bubble-no-way-says-alan-greenspan-20131024-2w2ky.html#ixzz2ih57UwLr


Related:

Equity valuations relative to bond market
http://myinvestingnotes.blogspot.com/2010/07/equity-valuation-s-500-relative-to-bond.html

When is the market over-valued?
http://myinvestingnotes.blogspot.com/2009/07/when-is-market-over-valued.html

The Market P/E of KLCI on 7.6.2013 was 16.2.

7.6.2013
KLCI (30 Component Stocks)

Stock Code Stock Name Last Mark. Cap PE DY NTA 1015 AMBANK 7.41 22335.1 13.6 3 3.99 6888 AXIATA 6.7 57142.4 22.3 5.2 2.36 4162 BAT 63.8 18216.8 22.8 4.3 1.7 1023 CIMB 8.16 62145.3 14 2.9 3.82 6947 DIGI 4.67 36309.3 30.1 5.6 0.03 5398 GAMUDA 4.7 10496.1 17.8 2.6 1.95 4715 GENM 3.94 23393.7 15.9 2.2 2.32 3182 GENTING 10.44 38831.4 9.7 0.8 5.87 5819 HLBANK 14.12 26544.3 14.2 2.7 6.52 1082 HLFG 15 15791.5 13.5 1.7 8.07 1961 IOICORP 5.31 34155 19.1 2.9 1.97 2445 KLK 21.44 22887.3 18.9 3 6.68 6012 MAXIS 6.75 50629.9 27.3 5.9 0.94 1155 MAYBANK 10.44 90688.6 14.4 6.2 5 5186 MHB 3.4 5440 22.5 2.9 1.57 3816 MISC 4.98 22229.7 0 0 5 2194 MMCCORP 2.82 8587.1 9.3 1.6 2.31 1295 PBBANK 16.98 59972.1 15.4 2.9 5.12 5183 PCHEM 6.6 52800 15 3.3 2.54 5681 PETDAG 26.1 25929.1 31 4 4.84 6033 PETGAS 21.2 41949.1 29.9 2.4 4.63 4065 PPB 13.74 16288.8 19.3 1.5 12.04 1066 RHBCAP 8.64 21549.9 10.9 2.6 6.06 4197 SIME 9.49 57029.8 13.7 3.7 4.33 5347 TENAGA 8.29 46565.7 10.8 2.4 6.57 4863 TM 5.41 19353.7 15.3 4.1 1.93 4588 UMW 14.7 17173.9 18.1 3.4 4.11 4677 YTL 1.73 18578.4 14.7 1.2 1.25 6742 YTLPOWR 1.52 11153.9 9 3.1 1.3 SUM        934,167.9

Stock Code	Stock Name	Earnings	Dividend	BV	ROE	No of shares
1015	AMBANK	1642.3	670.1	12026.6	13.7%	3014.2
6888	AXIATA	2562.4	2971.4	20127.8	12.7%	8528.7
4162	BAT	799.0	783.3	485.4	164.6%	285.5
1023	CIMB	4439.0	1802.2	29092.5	15.3%	7615.8
6947	DIGI	1206.3	2033.3	233.3	517.2%	7775.0
5398	GAMUDA	589.7	272.9	4354.8	13.5%	2233.2
4715	GENM	1471.3	514.7	13775.0	10.7%	5937.5
3182	GENTING	4003.2	310.7	21833.4	18.3%	3719.5
5819	HLBANK	1869.3	716.7	12257.0	15.3%	1879.9
1082	HLFG	1169.7	268.5	8495.8	13.8%	1052.8
1961	IOICORP	1788.2	990.5	12671.4	14.1%	6432.2
2445	KLK	1211.0	686.6	7130.9	17.0%	1067.5
6012	MAXIS	1854.6	2987.2	7050.7	26.3%	7500.7
1155	MAYBANK	6297.8	5622.7	43433.2	14.5%	8686.6
5186	MHB	241.8	157.8	2512.0	9.6%	1600.0
3816	MISC	0.0	0.0	22319.0	0.0%	4463.8
2194	MMCCORP	923.3	137.4	7034.1	13.1%	3045.1
1295	PBBANK	3894.3	1739.2	18083.5	21.5%	3531.9
5183	PCHEM	3520.0	1742.4	20320.0	17.3%	8000.0
5681	PETDAG	836.4	1037.2	4808.3	17.4%	993.5
6033	PETGAS	1403.0	1006.8	9161.5	15.3%	1978.7
4065	PPB	844.0	244.3	14273.4	5.9%	1185.5
1066	RHBCAP	1977.1	560.3	15114.9	13.1%	2494.2
4197	SIME	4162.8	2110.1	26021.0	16.0%	6009.5
5347	TENAGA	4311.6	1117.6	36904.3	11.7%	5617.1
4863	TM	1264.9	793.5	6904.4	18.3%	3577.4
4588	UMW	948.8	583.9	4801.7	19.8%	1168.3
4677	YTL	1263.8	222.9	13423.7	9.4%	10739.0
6742	YTLPOWR	1239.3	345.8	9539.5	13.0%	7338.1
	SUM	57,735.0	32,429.8	404,189.0

KLCI 30 COMPONENT STOCKS			RM (m)
TOTAL MARKET CAP			934,167.9
TOTAL EARNINGS			57,735.0
TOTAL DIVIDENDS			32,429.8
TOTAL BOOK VALUES			404,189.0
Market PE 16.18 Market DY 3.47% Mark cap/BV 2.31 ROE 14.28% Earnings Yield 6.18% Risk free interest 3.50% Equity Risk Premium 2.68% (Fairly Priced) KLCI 7.6.2013 1775.59

KLSE Market PE is 16.6 (11.1.2013)

KLCI	11.1.2013
Index Stock	Price		Mkt. Cap		Earnings		Dividends		Equity
Stock Name	RM		RM (m)		RM (m)		RM (m)		RM (m)
AMMB	6.64		20014.2		1527.8		600.4		11152.5
CIMB	7.66		56935		4037.9		1651.1		25940.4
RHB	7.9		19704.2		1713.4		630.5		12944.9
HLFG	14.42		15180.9		1167.8		258.1		8495.8
MBB	9		75960.7		5798.5		3038.4		36967.5
PBB	16.2		57217.2		3510.3		1716.5		14975.4
IOI	5.05		32475.5		1794.2		1006.7		12668.7
MMC	2.63		8008.5		333.7		120.1		6211.9
KLK	22.48		23997.5		1212.0		695.9		7130.9
GENTING	9.51		35372.3		2875.8		283.0		17741.9
PPB	13		15411.5		981.6		277.4		14060.0
BAT	60.9		17388.8		718.5		782.5		431.2
SIME	9.59		57630.8		4146.1		2074.7		26021.0
UMW	12.4		14486.8		503.0		362.2		4264.3
YTL	1.81		19395		1259.4		213.3		13394.3
GENM	3.61		21434.3		1498.9		514.4		12528.1
TM	5.82		20820.5		1189.7		707.9		6975.9
AIRASIA	2.89		8033.9		565.8		136.6		4058.6
UEMLAND	2.15		9307.1		313.4		0.0		4848.3
PETCHEM	13		49840		2637.0		1295.8		9623.0
MHB	4.4		7040		206.5		161.9		2432.0
ARMADA	3.82		11189.4		428.7		78.3		3544.3
TENAGA	6.92		38349.9		4261.1		1112.1		36410.2
PETDAG	22.96		22809.7		655.5		798.3		4778.5
HLBANK	14.98		49128.8		2532.4		2996.9		3542.0
MAXIS	6.55		49128.8		2532.4		2996.9		8100.6
PETGAS	18.98		37556.3		1082.3		788.7		8884.5
YTLPOWER	1.6		11740.7		1249.0		340.5		9539.3
AXIATA	6.69		56920.8		2381.6		1593.8		19399.0
DIGI	5.17		40196.8		1252.2		1366.7		1399.5
			902675.9		54366.7		28599.8		348464.7
Market PE	16.60
DY	3.17%
DPO	0.53
Mkt cap/BV	2.6
ROE	15.6%
EY	6.02%
Risk free int.	3.40%
ERP	2.62%	(Fairly  valued)
KLCI
11.1.2013	1682.7

Related:

KLSE Market PE is 17.7 (19.10.12)

KLSE Market PE is 17.7 (19.10.12)

KLCI	19.10.12
Index Stock		M.Cap	Earnings	Dividends	Equty (BV)
Stock Name	Price	(RM m)	(RM m)	(RM m)	(RM m)
AMBANK	6.44	19411.3	1528.4	601.8	11152.5
AXIATA	6.68	56828.1	2377.7	1591.2	19396.4
BAT	64.00	18273.9	719.4	785.8	431.1
CIMB	7.62	56637.7	4016.9	1642.5	25940.4
DIGI	5.48	42607.0	1253.1	1363.4	1399.5
GAMUDA	3.43	7139.1	549.2	249.9	4058.7
GENM	3.59	21315.5	1501.1	511.6	12528.1
GENTING	8.75	32545.5	2880.1	292.9	17741.9
HLBANK	14.20	26694.7	1866.8	720.8	2312.3
HLFG	12.84	13517.5	1165.3	256.8	8495.8
IOICORP	5.06	32530.5	1787.4	1008.4	11122.1
KLK	21.42	22865.9	1577.0	914.6	7088.2
MAXIS	6.87	51528.5	2525.9	2988.7	8100.6
MAYBANK	9.09	75142.9	5692.6	3005.7	36207.5
MHB	4.74	7584.0	206.6	159.3	2432.0
MISC	4.23	18881.8	0.0	0.0	22318.9
MMCCORP	2.70	8221.7	334.2	123.3	6212.0
PBBANK	14.88	52555.0	3503.7	1681.8	14975.3
PCHEM	6.56	52480.0	2637.2	1259.5	20080.0
PETDAG	22.24	22094.4	655.6	795.4	4778.5
PETGAS	19.70	38981.0	1079.8	779.6	8864.7
PPB	12.60	14937.3	982.7	268.9	14060.0
RHBCAP	7.48	16723.5	1534.3	568.6	11603.6
SIME	9.79	58832.6	4143.1	2118.0	26021.0
TENAGA	6.96	38348.4	504.6	230.1	30469.3
TM	6.05	21643.3	1189.2	692.6	6975.9
UMW	10.08	11776.4	503.3	365.1	4264.3
YTL	1.79	19033.9	1252.2	209.4	13291.8
YTLPOWR	1.63	11956.2	1245.4	346.7	9535.6
TOTAL		871087.6	49213.0	25532.2	361858.0
Market PE		17.7
Market DY		2.9%
Mark cap/BV		2.4
ROE		13.6%
Earnings Yield		5.6%
Risk free interest		3.5%
Equity Risk Premium		2.1%	(Fairly Priced)
KLCI
19.10.2012		1666.35

https://docs.google.com/open?id=0B-RRzs61sKqRS1pfNC12NHlhOWM

Is the KLSE overvalued? 15.12.2011

KLSE Composite Index:  Market Valuation

15.12.2011

KLSE Market PE Ratio 15.05
Div Yield 3.42%
Price/Bk Value 2.15
KLSE CI 1,464.11

Earnings yield = EY = 1/PE = 1/15.05 = 6.64%
Risk free FD interest rate = 3.4%
Equity risk premium = 6.64% - 3.4% = 3.24%

Equity risk premium is the compensation investors require for holding stocks.
Equity risk premium = earnings yield (1/market PE) - the risk free rate.

More than 3.5%, market is undervalued
0.6% to 3.5%, market is fairly valued.
Less than 0.6%, market is overvalued

So, presently, by the above criteria of equity risk premium, the market is neither undervalued nor overvalued, and is at fair value.


Read also:
http://myinvestingnotes.blogspot.com/2009/07/when-is-market-over-valued.html

Is the KLSE overvalued?  5.10.2010

http://myinvestingnotes.blogspot.com/2010/10/is-klse-overvalued.html

Is the KLSE overvalued?

5.10.2010

KLCI 1462.27
Market PE of KLSE = 17.48
Earnings yield = EY = 1/PE = 5.7%
Risk free FD interest rate = 3.0%
Equity risk premium = 5.7% - 3.0% = 2.7%

Equity risk premium is the compensation investors require for holding stocks.
Equity risk premium = earnings yield (1/market PE) - the risk free rate.

More than 3.5%, market is undervalued
0.6% to 3.5%, market is fairly valued.
Less than 0.6%, market is overvalued

So, presently, by the above criteria of equity risk premium, the market is neither undervalued nor overvalued, and is at fair value.

http://myinvestingnotes.blogspot.com/2009/07/when-is-market-over-valued.html

Equity Valuation (S&P 500) Relative to Bond Market

Is the market over-valued?

9.10.2009
KLCI index 1230.09
Market PE 23.53
EY = 1/PE = 4.25%
Risk free FD interest rate = 2.5%
Equity risk premium = 4.25 - 2.5 = 1.75%


Equity risk premium  = earnings yield (1/market PE) - the risk free rate.

 > 3.5%, market is undervalued
<  0.6%, market is overvalued
0.6% to 3.5%, market is fairly valued.

So, presently, the market is neither undervalued nor overvalued, but trading at fair value.


http://myinvestingnotes.blogspot.com/2009/07/when-is-market-over-valued.html

How best to allocate your funds?

To a certain extent, that depends on your risk appetite, which in turn hinges on your individual circumstances.

A risk-averse investor may hold more cash, and a risk-tolerant investor vice-versa.

Allocation will also depend on market conditions.

Equity risk premium can be a good guiding principle for asset allocation decisions, i.e., when to hold cash and when to hold stocks if you are looking at just 2 asset classes.

Even if you have high tolerance for risks, it would be foolish to allocate 80% of your portfolio to equities during a stockmarket bubble.

And even, if the market was "normal" when you allocated your assets, prices will move, leaving you holding more of one asset class than you desire. In which case, you might want to rebalance your portfolio.

Stocks, bonds or cash? How much you hold of each asset class - or asset allocation - is the most important decision in an investment process. Studies have shown that about 95% of variations in returns on portfolios are explained by asset allocation decisions. Only about 5% are due to other causes, such as security selection.

Ref: Show Me the Money by Teh Hooi Ling

When is the market over-valued?

The stock market moves in a cycle - from extreme optimism to extreme pessimism. How can you tell when stocks are under or over-valued vis-a-vis bonds or cash? Taking advantage of perceived over or under-valuation of securities in different asset classes can yield spectacular results.

Equity risk premium:

> 3.5%, market is undervalued
< 0.6%, market is overvalued.
0.6% to 3.5%, market is fairly valued.

Equity risk premium is the compensation investors require for holding stocks.

When the economic outlook is bad, or in the aftermath of a catastrophe, the equity risk premium will be high because fear grips investors and they can only be enticed to hold "risky" stocks if the promised returns are good.

Conversely, in good times everyone become over-confident of the continued good performance of stocks and will demand very little compensation to hold them.

Equity risk premium
= earnings yield (1/market PE) - the risk free rate.

Market PE ratios were obtained from Thomson Financial Datastream.
One-year deposit rates were taken as risk-free rates.

Ref: Show Me the Money by Teh Hooi Ling